Financial Services

February 22, 2008

FINANCIAL SERVICES (DIVERSIFIED)

The Financial Services (Diversified) Industry is an amalgamation of insurance companies, credit businesses, asset managers, and other consumerrelated finance operations. The industry is impacted by fiscal and monetary policy, interest rates, credit factors, asset quality, demographic trends, and increasing globalization. Credit Is Critical The credit boom that created many first-time homeowners has run its course. Banks, securities firms, and GSEs (government-sponsored entities), including Fannie Mae (FNM) and Freddie Mac (FRE), all bought loans from originators, and bundled them into bonds known as asset-backed securities (ABS), giving the originators more cash to lend for additional mortgages. This process, known as securitization, combined with low interest rates and the advent of credit insurance to boost liquidity and distribute default risk worldwide. The inevitable slowdown in the real estate market has pushed housing prices down, meaning that home-owners and speculators that were counting on continued price appreciation have found themselves in a difficult situation. Some borrowers are defaulting on their mortgages because the value of their homes has fallen below the value of their mortgage loan. Too, others that had taken out low interest rate ‘‘teaser’’ loans have found that they can not meet the higher payments when the loans reset at higher interest rates. Capital Is Critical, Too Firms that own the ABS are required to reflect the value of those assets when they report their quarterly operating results. The valuation of the holdings is derived by a process known as marking to market. Indeed, the securities are deemed worth what the market is willing to pay for them. That said, the valuation process is not exact, and in the case of illiquid securities, the valuations are sometimes calculated by computer-driven models that attempt to state a more exact value. Many well-known financial services firms have recently been making headlines by disclosing charge-offs related to their ABS holdings. The charge-offs, also known as write-downs, reflect the decline in the securities valuation, and therefore also decrease capital levels, which are funds available to support the long-term viability of the business. The deterioration in capital is worrisome because it leaves less of a cushion with which to absorb possible future losses. Too, firms have less wherewithal to make loans or investments, limiting future profitability.Large financial firms have been raising capital in an attempt to solidify their balance sheets, so that customers and regulators alike have greater assurance they will remain ongoing entities. Public and private stock and bond sales to domestic and foreign entities are making headlines, as the firms scramble to replace the capital lost through the charge-offs. In general, it appears that managements are prioritizing capital retention and dividend safety. Sharerepurchase programs have slowed in an effort to support existing dividend payouts. That said, some firms, including Citigroup, have elected to reduce their dividends so that their capital base meets industry and regulatory benchmarks. While most firms would strongly prefer to not cut their dividend, and relatively few have to date, we note that dividend reductions historically have oc-

2128

INDUSTRY TIMELINESS:

77 (of 97)

curred late in the credit cycle, meaning that we would not be surprised to see additional dividend cuts. Monolines Under Pressure Originally serving municipalities as their only customer base, (hence their name - monolines), the bond insurers (AMBAC, MBIA) are in danger of having their credit ratings downgraded because of the collapse of the subprime ABS market. The insurer’s claims-paying ability is in some question because the bonds that they have insured are defaulting at an unprecedented rate. Unfortunately, a downgrade of an insurer has a domino-like effect. Debt backed by the insurers is now deemed more risky as well, which may cause additional writedowns (in the case of banks), or more expensive borrowing (in the case of municipalities). Investors who are tempted to purchase the now higher-yielding municipal obligations are reminded that there is no free lunch in the financial markets, and that some municipal bonds may now contain more risk than previously. Investment Advice It is difficult, if not impossible, to know how high credit losses and charge-offs will go, and how long the downturn will last. Declining home prices, coupled with rising housing inventories and unemployment, create significant uncertainty. Too, although we are not forecasting a recession at this point, consumer finance companies are starting to increase their loss estimates even as consumer credit card spending appears to be shifting toward essentials (gas and groceries) and away from discretionary items (plasma TVs). We encourage investors, by and large, to avoid new commitments to this sector. While we are aware that share-price levels have in some cases declined substantially, we believe that significant uncertainty remains regarding the scope and duration of the challenges facing the financial services sector. Too, the effectiveness of recent fiscal and monetary policy actions is unknowable, and historically has had a lagged impact. Douglas G. Maurer, CFA

Financial Services (Diversified) RELATIVE STRENGTH (Ratio of Industry to Value Line Comp.) 8 00 0

6 00 0

4 00 0

2 00 0

2 002

2 003

2 004

20 05

2 006

2 007

2 008

Index: June, 1967 = 100

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